To buy securities on margin is to fund the purchase (or short sale, as the case may be) and continued holding of the security or derivative with borrowed money, using the security positions and monies in the margin account (or a linked account) at the dealer as security for the provision of credit by the dealer to the client. Financial institutions other than the client’s dealer, such as trust companies, credit unions or banks, may also lend money to the client, for the express purpose of the investor client utilizing the resulting leverage to purchase securities, typically mutual funds in his or her account at the dealer. In such cases, security for the loan can be the client’s residential or other real estate, the securities purchased with the borrowed funds, or other assets of the client.

In recent times, Courts in Canada adjudicating securities actions involving issues of margin and leverage (whether dealer initiated claims against their clients for monies owing in their accounts, or clients’ claims against dealers for investment and trading losses suffered in their accounts) have greatly expanded the ambit of judicial analysis. Historically, cases focused entirely on the contractual debtor/creditor issues raised by clients’ borrowing of money from dealers to fund their trading and security positions, and the consequences of the account becoming undermargin. More recently, the analysis has centered on the dealer’s Know Your Client and suitability obligations to its clients, with the starting point being the client’s investor profile, including his or her investment objectives, risk tolerance and financial and personal situation. As well, breaches of securities regulatory requirements have become an important factor in the analysis of dealer liability to clients.

Instead of margin lending being an issue that solely impacted a dealer’s own capital and ultimately its solvency, margin borrowing and the use of leverage has also become a part of the analysis of the propriety of the dealer’s (including its sales representatives’) conduct of its clients’ investment accounts. The increased risk of loss that is inherent in investing on margin or in a security in which leverage is a component part, such as a derivative or some principal protected notes, is thus a suitability issue that informs the duty of care owed at law by dealer to client.

This shift is not unique to margin, but has also occurred in respect of other traditional dealer capital issues, such as guarantees and concentration. The emphasis is now on a dealer’s duties to its clients, as opposed to contractual terms of the relationship set out in account documents, or the client’s own conduct. These duties are based on common law obligations focused on the nature of the dealer/client relationship, on securities regulatory requirements, industry practices and the dealer’s own policies and procedures. In the case of margin, it is not uncommon for a dealer’s own margin policies to be more stringent than required by securities regulations.

Court decisions of investment loss cases involving margin/leverage are a window into issues arising from the dealings between dealers and their clients, and the resulting investment losses often at the heart of the ensuing litigation. Like any window, the view is one perspective, in this case on the intersection between financial institutions and individuals at the retail investing level as it has evolved over the last century. At times, the fact situations seem almost fictional in nature, underscoring the range of human conduct, from the pedestrian to the bizarre, in the quest for profit from the utilization of capital for the purposes of investment and speculation.

Historically

"In exercising his ordinary functions in marginal transactions, therefore, the broker acquires, so to speak, a dual personality. When he executes the order he is the customer’s agent, buying from or selling to a third party. When he provides funds to complete the order and to carry the securities purchased, he deals with his customer as a principal, advancing his own money and retaining the customer’s property as security, with all the rights and obligations which attach to an ordinary loan of money on the security of personal property."

Historically, agency, contract and debtor/creditor law governed the terms of the debtor/creditor relationship (between client and dealer) and the legal analysis of the conduct of the parties relating to the transactions and account at issue. Litigation between client and dealer involving margin issues generally focused on the terms of the borrowing agreement between the parties and the resulting respective obligations.

More Recently

The 1990’s mark the start of 2 plus decades of pronounced litigation between investor clients and dealers, amid a changing regulatory landscape and the judicial application of an expanded universe of dealer duties to their retail clients. In these decisions there tends to be a marked emphasis on the nature of the relationship between client and financial advisor, as well as the circumstances of the trading giving rise to the matters at issue (usualy investment losses). Over time, there appears to be a diminishing emphasis and importance on the account documentation, including margin and other account agreements containing terms and conditions governing the opening and operation of accounts, risk and other disclosures, and confirmations of transactions and statements of account. The plaintiff, heretofore usually the dealer claiming in contract against the client for the unsecured debit balance in the client’s account, now more frequently is the client, claiming against the dealer and its representatives for damages for breach of contract, negligence and breach of fiduciary duty.

The margin issues arising in these more recent cases became not only a credit issue but also a suitability issue as to whether the trading in securities and/or the holdings in the account were appropriate for the investor client.

Analysis

A statistical analysis of dealer and client-initiated claims (and counterclaims) is complicated by common knowledge that in recent times the overwhelming number of claims has settled prior to a trial judgment. Whether it is the average case that survives to trial and judgment, or only those with specific qualities (such as a plaintiff investor who views the litigation as another speculative investment, or an unreasonable dealer) is unknown, but clearly the cases that are adjudicated are a small subset of the overall multitude of client claims against dealers for investment losses.

In some instances, the trial or appellate conclusions resulted in partial success for one of the parties, with deductions for fault related findings reducing the award of damages. What is apparent from this review of cases is that in the period:

(c) 2000 to 2015, there were only two dealer initiated claims, and client claims results were mixed, with a far greater number of claims by clients than in the prior period.

The results of the older cases, being mostly in favour of dealers in debt collection cases, is not surprising, given the strict debtor/creditor contractual focus of the judicial analysis of margin/leverage issues. The decrease of dealer initiated claims for monies owing resulting from account liquidations, particularly since 2000, is fairly stunning, but may be explained by better dealer supervision of their lending practices. While the number of successful client initiated claims has increased, the overall results for client success are still mixed. The absolute number of client-initiated claims has grown substantially. While it is difficult to extrapolate anything meaningful from the numbers per se, it is apparent from the more recent decisions that there has been a change in the analysis conducted by Courts. Account agreements and documents do not automatically dominate the findings. Dealer duties at common law, imposed by securities regulation informed by industry practices, and the dealer’ own policies and procedures, play the most important part of recent decisions, with the client’s own conduct still a factor, though tending to be less important to the overall result.

Whether class action liability can be imposed on dealers for advice to an alleged class of clients to borrow to invest has not been sufficiently tested to be able to ascertain if class proceedings are a possible and effective dispute resolution mechanism. While certification was granted in one such case, the case settled prior to the appeal, and the Judge who approved the settlement cast doubt on its correctness. In two other cases, certification as a class proceeding was ultimately denied.

Finally, it is interesting to note that investors who have suffered investment losses in their accounts at dealers have not been successful in expanding the ambit of liability to third party financial institutions that lent them the funds to invest, even when the dealer and lender have a relationship that linked the borrowed funds to the client’s account at the dealer. Whether the judicial reliance on a traditional debtor/creditor analysis will continue in the present context, where borrowing to invest is itself viewed as involving investment advice and the resulting duties to investor borrowers, is yet to be determined.